JPMORGAN: Cyprus Could Still Default, And The Market Is Underestimating The Risks

Markets have mostly shrugged off the news out over the weekend that the EU bailout of the Cyprus banking system will contain a controversial haircut on depositors – an unprecedented move in this era of euro area bailouts and restructurings.

European markets took a bit of a hit yesterday, but nothing on the scale that would indicate investors in Spain and Italy, for example, are worried about the fallout from the Cyprus deal.

In a note titled "Why the market is underestimating Cyprus," JPMorgan economist Alex White challenges this notion, explaining why the Cyprus deal could still spoil the party in Europe.

"While the probability of an outright failure and default remains low," says White, "it is still possible, in our view; existing as a low probability, high impact risk."

Cyprus is trying to renegotiate the terms of the haircut on depositors, which has left many Cypriots furious at the prospect of part of their savings accounts being confiscated.

The original plan was to expropriate 6.75 percent of deposits from bank accounts with balances of less than 100,000 euros and 9.9 percent of deposits in accounts with over 100,000 euros. Distributing the levy this way got Cyprus to the total 5.8 billion euros demanded by the EU as the Cyprus contribution to the bailout.

The levy against insured depositors – those with less than 100,000 euros in their bank accounts – has been almost universally condemned, and there probably isn't much chance of getting the deal passed through the Cypriot parliament as-is because of this.

As White explains, this leaves Cyprus with no good options at this point. They still have three less-than-good options, but all are wrought with serious problems.

The first option is to remove the levy on insured depositors and shift the entire burden of it to uninsured depositors – those with over 100,000 euros in their accounts. However, in order to get to the total 5.8 billion euros, the levy on uninsured depositors would have to be hiked to 15.4 percent.

This is a problem, because a significant portion of those uninsured deposits come from moneyed Russian interests looking to use the Cypriot banking system as a tax haven.

"There is some possibility that Russia would respond to a larger haircut by refusing to roll its existing €2.5bn loan to Cyprus; meaning that this option would still leave a significant shortfall," says White. "In such a scenario, either the haircut on uninsured deposits would need to be around 21.8%, or further Troika funding would need to be found."

The second option, then, is to go straight back to the EU for additional support. However, given the ostensible reason that the EU asked Cyprus to chip in to the bailout so much to begin with – a looming German federal election in September – White says it's unlikely that German politicians will be interested in any sort of "U-turn." In fact, going back to the EU could make things worse if EU leaders manage to further complicate the situation.

The third option is to go with a more progressive levy. One proposal is to subject depositors with less than 100,000 euros in their accounts to a smaller levy – 3 percent from 6.75 percent – while making those with between 100,000 and 500,000 euros pay 10 percent, and those with more than 500,000 euros pay 15 percent.

This probably won't do much to appease those offended by this idea of deposit expropriation, meaning a plan like this might not make it through parliament either.

"Cypriot depositors are angry at what they perceive as a smash and grab raid, tweaking the quantum is unlikely to change their prevailing emotions," says White.

Those are all of the obvious problems in the short term.

White writes there are also longer-term implications for the whole euro zone, though (emphasis added):

In the longer-term, we expect significant ongoing ripple effects from the revealed preferences and attitudes that have emerged in the Cypriot case. Firstly, the affair reflects a change of behaviour amongst the policy making community, which looks more willing to accept risk in an OMT world. Secondly, it hints at a far more hawkish German attitude than we expected, which could have implications for the implied willingness to intervene in extremis elsewhere in the periphery (we will write more on this shortly). Essentially, we are seeing the rise of ‘the Germany that can say no’. Thirdly, these events are likely to lead to gradual change in the behaviour of depositors around the region.

We do not expect short-term bank runs or direct contagion, Near-term impacts on bank equity have been relatively limited so far (mostly in the 4% range). However depositors will now be aware that they are effectively taking a significant credit risk when they leave funds in weak banks backed by weak sovereigns – and there is a good chance that rates may need to rise in the periphery to reflect this increased perceived risk (indeed, we believe this action hints at broad risks for anyone with capital in a fiscally stressed country). The long-term implication for bank funding in the periphery is not a positive one, in our opinion, and by implication, there could be impacts on the supply of credit. Effectively, this would appear to work directly against the objectives of Banking Union, which is designed to ensure that a Euro in a Cypriot bank can ultimately be treated in the same way as a Euro in a German bank.

In other words, the Cyprus situation is still giving investors in bigger markets plenty of issues to consider going forward.